Good day, ladies and gentlemen, and welcome to the II-VI Incorporated Fiscal Year 2014 Third Quarter Earnings Conference Call. [Operator Instructions] Please note that today's conference is being recorded. I would like to hand the conference over to Mary Jane Raymond, Chief Financial Officer. Ma'am, please go ahead.

Thank you, Karen, and good morning. I am Mary Jane Raymond. I am the Chief Financial Officer of II-VI Incorporated. Welcome today to the II-VI third quarter earnings call for fiscal year 2014. With me on the call today is Francis Kramer, our Chief Executive Officer; and Dr. Chuck Mattera, our Chief Operating Officer. As a reminder, this call is recorded today, Thursday, May 1, 2014. Any forward-looking statements we may make during this teleconference are given in the context of today only, and we do not undertake any obligation to update these statements to reflect events subsequent to today. With that, I'll hand it over to Fran Kramer.

Thank you, Mary Jane. We're pleased to have you join the II-VI team as our new CFO, and we believe your experiences, education and discipline, growth-oriented style will help strengthen II-VI. In the just completed quarter, II-VI bookings were a company record of $187 million. That is a 12% increase over our prior strongest quarter. Revenues increased 21% year-over-year, a record $173.6 million for the quarter, and we're assisted by our most recent acquisitions in the Active Optical Products segment, which achieved $37.5 million of revenue in the quarter. In effect, those acquisitions provided the growth during the quarter. However, as we will discuss later, the challenge of establishing a firm business foundation for the acquired technologies and business is requiring a greater investment than we expected. As we work to get these acquisition-related investments and operating costs under control, we've looked hard at the best way to get the new acquisitions and technologies into our traditional, disciplined business management processes. We are evaluating a more efficient operational model and are moving II-VI Incorporated into simpler and coherent business segments focused on 3 areas: first, laser solutions; second, photonics products; and third, performance products. We target to align into these 3 segments at the beginning of fiscal year '15, although we are still fully operating in 5 segments, as Chuck and Mary Jane will describe. The new alignment will increase our focus on end markets and customers, who will better align our businesses and technical processes, and it will improve our line of sight on profitability and cash usage. Importantly, it will also simplify our communications. Our margin expectations going forward are considerably better than we have experienced since we closed the Active Optical Products Group-related acquisitions. Year-to-date, our gross margin is 33.2%; our operating margin, 6.4%; and our EBITDA margin, 14.9%. We expect our exit rate for FY '15 for all 3 of these metrics to be a minimum of 200 basis points better. Chuck, will you describe the steps we are taking to remain on the technology forefront and to digest these acquisitions, as well as some of the actions that are planned or underway to improve our profitability?

Thank you, Fran. II-VI has established a strong brand over the years by becoming the market leader in CO2 high-power laser optics and has delivered on a sustained track record of profitable growth based on leadership and quality, service and value. We remain committed to a strategic course for growth in businesses that have engineered materials at their foundation and which offer a composite value proposition to our customers that extends customers' roadmaps. A key element to our strategy is to utilize strategic acquisitions to supplement our organic growth. In fact, during the last 15 years, we completed 15 acquisitions and grew revenues over that period by over 20% compound annual growth rate. Through our acquisitions, our addressable markets and technical capabilities have been continuously expanded. Our 5 most recent acquisitions have resulted from another element of our strategy to capitalize on the benefits of vertical integration. Also, these acquisitions have given us increased market access through our expanded global footprint and have exposed us to sustained high-growth sectors, market-leading customers and new opportunities for leveraging capabilities in other parts of II-VI. Today, our business has enabled our customers to successfully compete in the face of their market realities, including when they confront significant technology inflection points in their own markets. Our current 5 operating segments address at least 6 major market segments across nearly 40 countries. And we believe we can streamline our current organization to improve our customer intimacy and our go-to-market strategies. So as Fran mentioned, we are evaluating moving to a market-based segment structure. We are currently in the planning phase but expect to ultimately consolidate the company into 3 segments that will center on laser solutions, photonics products and performance products. We expect that the more streamlined company will enable us to realize the benefits…

Thanks, Chuck. Thanks, Fran. Thank you for the nice welcome, and I am certainly happy to be here at II-VI. So turning to the financial highlights, the important quarterly and year-to-date comparisons are on Page 3 of our press release and some of those Fran and Chuck have already talked about at a high level. Our bookings of $187.5 million grew 35% in the quarter and 32% year-to-date, both compared to last year. Bookings grew in all segments, except the Advanced Products Group, which declined about $2 million on the non-recurrence of a large order we had last year, as Chuck already mentioned. Our book-to-bill ratio for the quarter was 1.08, growing our backlog to over $215 million, with $50 million in IR, $31 million in Near IR, $42 million in APG, $65 million in Military & Materials and $27 million in AOP. Revenues of $173.6 million grew 21% in the quarter and 25% compared to last year. Most of the revenue came from the AOP segment in the quarter, though its earnings were affected by the cost of stabilizing the operation, for which you've already heard a detailed plan from Chuck. Our gross margin for the quarter was 31.5% of revenue, down 390 basis points from the third quarter of last year. This decline is primarily from AOP due to restructuring charges and operating factors. The interest expense in the quarter was $1.4 million compared to $450,000 last year in the third quarter and is $3 million year-to-date compared to $700,000 for the same period last year. In increased interest, the company has increased draw on the credit line for the acquisition of our businesses that comprise the AOP segment. Our tax rate in this quarter was 5.5%. This is due to our usual mix of businesses that generate…

[Operator Instructions] Our first question comes from the line of Avinash Kant from Davidson & Co.

The question I had was, I think Fran talked a little bit about the model, especially the margin profile there you are targeting to be, and I believe he said by the end of fiscal year '15. Is that what he said?

Yes, exactly, exit of '15, 200 basis points higher.

So Fran, the way you talked about like the operating margin is roughly 6.4% and then gross margin is 32.2%, so you expect to be somewhere around 34%-ish in gross margin and 8.5% or so in operating margin by the end of 2015. Is that the target?

Yes. Add 2 to each one of those numbers I said. Yes, that's good.

And then what kind of revenue levels would you need and what kind of mix would you need to get to that kind of model?

Yes. I think you have to -- we haven't put out a guidance that far in order to tell you that, but certainly, our revenues would be up from what we're guiding for this year. I don't really want to step into that bucket. But they'll be up in the 5%, 6% range probably. And it should be a mix a little heavier than what we've had. IR, I think, will be a little bit better next year and so that will be helpful. But rest of the businesses will be about on the same pars we've been running, and AOP will achieve its annualized rate compared to where we are this time. So it's quite the same mix, we would say.

So basically, on similar mix and similar revenue levels, you should be able to achieve these margins, right?

Yes.

Okay. And in the guidance for the next quarter that you are talking about, what kind of margin assumptions do you have in mind?

I think our discussion about how much margin by segment is what we did in our script. I wouldn't be prepared to go deeper than that because it's such a complex story. And that's really somewhat, Avinash, why we're headed to 3 segments because the story -- in order for me to explain every one of those segments again and go deep enough to give you the answer you want, we're not prepared to do that.

I was looking more into just the -- on the corporate level.

On the what, please?

On the fully integrated basis. Like you had 31.5% in the current quarter, so what will be that number for June in the guidance that you've already given?

So I think, first of all, if you look at the guidance that we've given on the quarter, which is the balance from our full year of $670 million to $685 million, we obviously -- and the EPS of $0.55 to $0.60, we obviously would look at the fourth quarter being stronger. We also don't anticipate that the fourth quarter would have in it some of the things the third quarter did, for example, adjustments to inventory and the restructuring charge. So again, while we're not going to put a precise number out on the return on revenue, I would expect to see that it would rise up from the round of 5% we had in this quarter to something that might cross in the high-5s to low 6%, something like that, because just the exception of taking out the restructuring, et cetera, would help us.

Right. And the tax rate and interest expense, like interest expense, you can continue to model at $1.4 million kind of run rate?

Yes. And I think from a tax perspective, if you think about having $5.5 million in this year for kind of around 20% for the whole year, the tax rate in the fourth quarter is probably closer to about 22% to 23%.

Okay, perfect. And one other question, Fran. Now talking about the business in general at this point, I know you have access to a lot of information, especially in terms of the utilization rate of gas leases and the systems out there. What kind of trend do you see at this point? And especially any particular region that you could point to, maybe China or something [indiscernible]?

On CO2 lasers, the utilization -- we have a model, and we update it every quarter. The number don't mean anything to anybody, but if you thought of a rate that's normal 60%, 65% utilization, that's approximately where we are right now. The numbers on our chart are almost exactly -- there are at least 72,000 CO2 lasers out there doing work and the number is coming down. There's CO2 high-power I'm talking about, high-power assembly line right now, will be on an annual rate of about $3,200. And you know the peak of that has been as high as $5,500. You can see the business is down from the assembly line. That's always been a feature that we see happening as the fiber lasers are doing quite a bit more, but the aftermarket business for us is a very good business. And that's the barometer of laser utilization is how well the aftermarket is performing. And in this quarter, the fourth quarter run right now, it's very good. So it's rather like provision where we have a high utilization in the April, May, June quarter.

Okay, so you have seen the trend improve lately, right, especially in the aftermarket?

Yes.

Yes. I think that, certainly, third quarter was better. Fourth quarter, we expect to continue to be better and benefit seems to cycle again.

But the trend in the CO2 laser utilization still is down or is still flattening, high-power CO2?

You said it's still what?

The trend.

Oh yes, it's still -- it will increase -- not much because this is good for utilization. It's really running well here in the fourth quarter. Now it all has a lot to do with round the world the economy, and it usually seems to have a better trend here before the summer happens. And that's why we end up picking up in the aftermarket business here in this quarter.

Our next question comes from the line of Jim Ricchiuti from Needham & Company.

I joined a little bit late, but it sounds like you're still a little bit more cautious on Military, on that portion of the business, Military & Materials. Would you anticipate Q4 being somewhat flat to down versus Q3?

On the Military side, no, it's going to be about the same, flat, maybe trending up a hair, but it's -- the orders that we have and the work we're doing in that area are pretty much programs, and those programs are running okay. If there is something that might be a little down in our Military, it's probably going to be on the order book side, and that leads into how business will be mid-next year and late next year. So we're pretty much ahead on bookings for this year. We'll finish the year in Military as we've guided.

Right. And then, actually, that gets to my next question. It's helpful the way you talked about your targets, the margin improvement for exiting '15. And I'm trying to get a sense as to how much of that improvement is going to hinge on the turn improvement in the Advanced Products Group. Is that the lion's share of the improvement you anticipate?

Really, the lion's share is what we call AOP, our Active Optical Products.

That's what I meant. I'm sorry, I misspoke. So that is the lion's share of it?

Yes, that's a good portion of it, yes. That's a portion that's been difficult for us in the last 2 quarters as you've probably seen.

And to get that kind of improvement, can you talk a little bit about -- and potentially, what kind of revenue levels you might need to see? Or is it not as contingent on that and just in terms of just getting involved in -- more in the internal steps you're taking in terms of reducing costs, working with -- potentially negotiating some other contracts? I'm trying to get a sense, is this going to be contingent on a much higher level of revenue from AOP?

I think it's contingent on the full year of the revenue that we've guided for. And I made a statement earlier, which I'm not really happy of having said it, but I think our revenues would be up 5%, 6%. It might be more or less. We're not giving guidance on FY '15, but trend-wise, we get the full year effect of AOP and a few of the other things that we're working on. That's the top line story. And then just what you said, it's very important. We've got to fix the internal processing of what we're doing at AOP in order to get ourselves 200 basis points better.

I think -- this is Mary Jane. I think another way to think about what Fran is saying is that the improvement in the AOP segment is not entirely dependent on revenue. The revenue is an important characteristic as it would be in any of our businesses, but getting our hands around the operating costs, the pricing of products at the right level, contract manufacturing, et cetera, are all part of the mix as well.

Got it. And again, you may have gone over this, but did you talk at all about any additional charges associated with business in Q4?

We did not talk about it. I mean, it's not our expectation to have additional charges in Q4. The charge that we took in the third quarter is the only charge we expect this year, though. As you could naturally imagine, there's some cash flow that follows for the recorded charge into the fourth quarter. But as for new charges, no.

Okay. And then in terms of the Q4, the -- what you see for potentially the loss in this part of the business. Should we anticipate some improvement?

With respect to -- well, first of all, as you know, we don't give guidance by segments. But having said that, if you think about the composite guidance for the quarter, which is $175 million to $190 million on the revenue side and then $0.15 to $0.20 on the EPS side, it certainly would imply something of a stabilization in the earnings here. But I don't know that they become spectacularly positive in the fourth quarter. But I do think that they begin to stabilize by way of more of the operations as time goes on here being in our hands.

And our next question comes from the line of Jiwon Lee from Sidoti.

Fran, you mentioned some pricing pressure on the consumer side of things. Could you elaborate a little bit?

Probably that would have been -- Chuck might have mentioned that, I think, in his script, but certainly, in our APG Group where we're working on the -- our personal comfort products that's more where we really see a pressure to be competitive. And some of our industrial CO2 laser optics, believe it or not, because they're so driven by laser utilization right now with many of the economies around the world doing better, people are thinking that the prices of even our CO2 optics should be coming down. And we hadn't -- well, we placed some pressure on that in the past, but now, it's a little more intense. And I think that intensity on price down is driven in China as China produces more consumer goods running their lasers, and so they're used to pricing everything down. So we're getting pressure there. I'll turn to Chuck if there's another comment on that.

I don't think so, Fran. I think the China -- the story of China in general, geographically, the communications market, generally, as a market where the pricing pressure is always strong and the competition for new products and new features to offset the pricing pressure just rolls on.

Okay, great. And then the HIGHYAG side. Where do we stand on the move and sort of the booking trends, please?

Yes, we've moved the operation, and it has created us some operating challenges. So it's not behind us. We're working hard on it and adding to our staff and, really, we're working on management of that operation because the management that was there was mostly associated with a prior 25% owner, so we're adding new management. And our orders have been so strong that we've just not been able to keep up. And in spite of that -- unfortunately, when you're not able to keep up, you're disappointing customers. So that's where we are right now. And yes, we're getting a little bit better, but we're still in that difficult time. And I think it's going to go through the quarter, although I think the fourth quarter from the numbers that are buried in the IR Optics due to HIGHYAG will be better than the third quarter.

Okay, good. And then the full topside, what type of sequential revenue assumptions directionally did you put in for the fourth quarter?

With respect to Photop, we see the revenue kicking up on third quarter at about, call it, 6-ish percent, which, I think, if we look at the segment in which Photop is fairly consistent with their normal Q3, Q4 movement.

Okay, great. And then for Mary Jane, did you discuss the backlog per segment?

I did discuss the backlog per segment. Do you want me to just give you that again?

I'm sorry about that. Could you?

No, it's fine. Don't worry about it. Sure. So let me just see here. The backlog in general -- but first of all, as Fran said, it's $215 million. So it goes like this: It's $50 million in IR, $31 million in Near IR, $42 million in APG, $65 million in Military & Materials and $27 million in AOP.

[Operator Instructions] And I see no further questions in the queue at this time.

All right, thank you, Karen. If there are no more questions, I'd like to thank everyone for participating with us today. Our next scheduled earnings release for the quarter ending June 30, 2014, is currently scheduled for Thursday, July 31, before the market opens, with the conference call to follow at 9:00. Thank you, all, for joining us today. Have a good morning.

Thank you. Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program, and you may now disconnect. Everyone, have a good day.